India: Taxing Time for Foreign Investors

Ignorance, they say, is bliss. But not for a country when the government ignores the ground realities while devising plans and policies. The recent union budget of India is a veritable test case of the above. Previously I have talked about how the budget over-estimated the revenue numbers and under estimated the expenditure numbers by ignoring the various risks (both endogenous and exogenous) lurking around. I will now talk about couple of ill-timed (read ill-advised) policy announcements that can further exacerbate the problems.

The lack of policy stability has been a big problem for India. The recent multiple episodes of corruption (cutting across party lines), political one-upmanship leading to policy logjams, clear evidence of the government losing control by the day etc. highlights the fact that the investment climate in the country has worsened. Since 2007, both savings and investment have been on a decline. Despite relatively good GDP growth numbers, foreign investors have not shown the appetite for rushing to India. The resource starved government’s stubbornly dedicated effort to make Vodafone pay taxes to the tune of USD2.3 billion as capital gains tax on a transaction in 2007 that involved the purchase of a controlling 67% stake in the Indian telecom company Hutch Essar from a company controlled by Hong Kong’s Hutchison Whampoa is a case in point. This became the talking point for international investors until India’s Supreme Court over-ruled the government’s contention and ruled in favour of Vodafone. As if this wasn’t bad enough, the Supreme Court played its part to further vitiate the investment climate by cancelling all the 2G licenses awarded earlier, in the process of trying to punish the guilty who were involved in the scam of awarding the 2G licenses. This gave the signal that investment in India can be risky as policies can change over time and can materially affect the existing investment. And then came the budget.

Here I am referring to two specific announcements – one relatively harmless (though it could have waited and been definitely better defined) and the other simply insane.

First, the softer one: the Introduction of GAAR or General Anti-avoidance Rules in the budget. Not that this came out of the blue. There has been some discussion around this even during the previous budget and this was supposed to be part of the DTC or the Direct Tax Code that is to be introduced in the future. The essence of this code is that if a transaction is designed with the sole purpose of avoiding tax, then that transaction would be taxed by superseding other existing laws. Surely this is not something new. There are many other countries that have GAAR provisions. In India’s case, this seems to have been triggered because the majority of capital flows into India (be it in the form of direct investment or portfolio investment) is routed through Mauritius with whom India has a DTAA (Double Tax Avoidance Agreement) Treaty. Indian tax laws allow for tax benefit to an entity if it can provide proof of residence (of Mauritius) for tax purpose. History of India’s FDI flows show that the majority of India’s direct investment has come through the Mauritius route. Similar is the case with FII (Foreign Institutional Investor) flows. The problem with the definition so far is that, it is defined in a way that leaves enough room for faulty interpretations. The GAAR provision can be triggered if the tax authorities can prove that the tax paid in India is lower than what could have been the case in a general situation. To make the matter even worse, the onus of proof lies on the tax assessees and not on the income tax department, which is generally the case elsewhere. This has the potential to complicate the working environment. More importantly, when GAAR is triggered, it will over-ride any other existing law. This means that, even if a transaction is clean under the Indo-Mauritius DTAA, the DTAA provisions will be over-ruled if GAAR is triggered. There is, therefore, a clear difference between the provisions GAAR and that of the DTAA and this is not healthy. Forex inflows have already started reacting to this new provision. Considering India desperately needs forex inflows, such moves are ill-advised. While the dust will eventually settle (GAAR, as a concept is not wrong), it will bring in a lot of uncertainty into the existing investment climate in the short to medium term.

However, what is really dangerous is the budget provision to amend tax laws retrospectively (going back to as much as 50 years). The aim is clearly (though the government denies it, as it quite often does to justify missteps) to over-ride the Supreme Court’s judgement on the Vodafone case and force it to cough up tax that has so far failed to stand up to the scrutiny of the existing Indian legal system. This has the potential to open up a Pandora’s box and many litigations will be under way as the desperate government seeks to garner revenues in whatever which way, cornered as they are by high levels of dual deficit. This clearly is a law which is very bad in spirit as it not only opens up several past transactions to scrutiny, it also reinforces the message that policies in India are unstable. One can understand prospective amendments of tax laws (as these can still be built into one’s business plan while taking investment decisions) but doing so retrospectively is nothing short of being draconian. That the foreign investment community is worried can be gauged from the fact that several global business giants (hailing from countries which are among the biggest investors in India) have made an appeal to the Indian Prime Minister to have a rethink on the retrospective clause. Even the British Prime Minister has voiced his concern in no uncertain terms. This clearly is a retrograde step that further vitiates India’s investment climate.

4 Responses to "India: Taxing Time for Foreign Investors"

  1. nitin   April 5, 2012 at 3:02 am

    Present Indian Government is most currupt in the history of India. As Dr. Singh is honest person but, he has no control over cabinet colleagues or even the secretaries of ministry which is held by himself. Last time, to much curruption was talked in India at time of Rajiv Gandhi (Husband of present president of ruling Congress Party). They are just passing the time.

  2. sanjay negi   April 6, 2012 at 12:12 pm

    Fact is that deficits are a way of life in Indian governance system…it is impossible to imagine deficits going away…governments therefore will try to extort whatever they can by tweaking laws and foreign investors who do not have any vocal constituency in India are the obvious soft targets…

    The only saving grace in the past few years has been that investment opportunities elsewhere have been even worse…so money has flowed into India for lack of better options.

    It is unlikely that the government will retract…the whole move has been well thought out…besides aiming at vodafone, the tax bureaucracy must be salivating at the prospect of opening up old cases and collecting lucrative mouthwatering bribes…

    India will not change until some avatar of Margaret Thatcher is born here….the constituency for market driven economics needs to grow considerably before any meaningful improvements can happen…Thatcher did it by ensuring that the people who invested substantially in capital markets vastly outnumbered those in labor unions…therefore she was able to easily push through appropriate legislation and disengage government from commercial activity…

    In India, at least the ruling congress party has a huge stake in letting the government sector grow…the presence of this sector helps the congress party suppress private sector and makes large imports like defense and infrastructure projects look rational…there are huge kickbacks collected in these imports and these are credited directly to foreign accounts in tax havens…so the congress party would not do anything that erodes the potential kickbacks….so it looks like a downward spiral….it is important to have a large government sector to have large imports….large government sector means a large constituency obstructing all market economics…so there will always be large deficits…

    Foreign capital flows will happen if there are no better opportunities in other countries…if these dry up, there will be a crisis and then every twenty years or so there will be some desperate minimum reforms so that the country does not collapse totally…after all the golden goose has to be kept alive even if means force feeding…

  3. Guest   April 10, 2012 at 2:44 am

    IF the US exim bank has supplied loans to Air India under Praful Patel http://en.wikipedia.org/wiki/Praful_Patel, then it has violated Foreign Corrupt Practices Act!

  4. kietgene   May 18, 2012 at 11:17 pm

    India will soon see the downturn in next 1 or 2 years .
    The politics are doing nothing either be India shining or dooming , they are fooling poor for petty votes and looting the public money so when the recession comes , they still can afford luxury.
    The market cycle has been 1992-2000-2008-2016 ????